by Tim Isbell (Posted 3/2013, Revised 1/2014, again 9/2016 to increase the recommended international stock allocation to 30%.)

Asset Allocation is the mix of our investments among various asset classes. In most portfolios, the two main asset classes are stocks and bonds. Here is the order of the impact of the four biggest factors affecting returns:

Over the past 200 years, the real (inflation-adjusted) rate of return on stocks was nearly 7%/year; while the real return on bonds was about 3.5%. If we start the calendar at 1926, the beginning of the “modern stock market,” the data is the same. Looking ahead, the Gordon Equation suggests the expected return of stocks and bonds is in the same ballpark. So it is reasonable to assume that if we remain invested long enough our "equity premium" (the benefit of holding stocks over bonds) will be 3-4% in "real" (inflation-adjusted) terms.

The stocks/bonds percentage in our portfolio is the biggest determiner of the volatility of our portfolio. More on this later in this web page.

The percentage of stocks is the biggest determiner of how much our portfolio grows. History indicates that we can increase this a bit if we build some tilt into our stocks towards small cap and value (see Glossary: Stocks). History also shows that the best way to reduce our portfolio's volatility is to mix in an appropriate percentage of bonds. (see the Efficient Frontier)

This web page helps us find an asset allocation between stocks and bonds that:

Fits our risk tolerance, and

Predicts the return over the long term.

Setting stocks/bonds allocation

There are two main items driving an optimum asset allocation: our age and our risk tolerance. Here are three ways for an investor to set their asset allocation.

100-your age formula

This first method has been around for a long time, and it is so simple that it only takes only 10 seconds. It is based on only one fact about us: our age. So we might think it is pretty useless, but it is a good first estimate. Here's the 1st way: Make your stock percentage equal to your age minus 100 (some say 110); put the rest of your money in bonds. I'm 67, so the Easy Formula suggests that I put 43% in stocks and 57% in bonds.

More evidence supports this concept than we may think. When we are 25 years old, most of us have very little financial capital. But we have lots of human capital, meaning we have a lot of earning years ahead, when we can pump money into investments. Economists consider human capital like a owning a bond, with an appreciating yield over time! So, early in our lives, we can invest more in stocks because our human capital serves as the bond portion of our portfolio.

By the time we turn 55 our human capital has decreased substantially. Hopefully, by then we've accumulated an adequate supply of financial capital. So as we age, we need to shift increasing amounts of our financial capital into actual bonds to balance our Asset Allocation. For more on this concept, see William Bernstein's Investor's Manifesto... (chapter 3).

Online Calculator

This method is more comprehensive. It takes about 10 minutes to fill out an online questionnaire to find our optimum asset allocation. Here's a good, free one: Vanguard’s online asset allocation calculator. There's no login required. I used it recently, and it recommended a 50% stock allocation for us. This is a higher than the previous method; maybe that means we are willing to take more risk than others my age.

So now we have two asset allocation suggestions. We won't be far off if we use their average.

Actual worst case returns data

This approach uses a chart of 5 asset allocations. For each asset allocation, the chart shows

Calculated long-term returns expectations for each asset allocation,

along with actual worst-case returns for 1 and 3-year stretches over a recent 20-year period.

You can find this chart at Portfolio Expectations. Because this method quantifies downside risk, it provides confidence that investors need to stay invested during the inevitable down markets that occur along the way.

Since setting the asset allocation is the single biggest determiner of returns, and all three ways of setting your asset allocation are pretty easy - use them all. Then stare at the three results for a few minutes and it will be easy to settle on the asset allocation that fits you. Every five years or so it's good to go through this same exercise because your risk tolerance may have shifted due to age or other life circumstances.

Suppose you decide on this asset allocation:

50% stocks

50% bonds

This split establishes about 80% of our long-term return. Now let's take a look at an implementation.

Implementing an Asset Allocation

Here's a chart of a reasonably complex portfolio. I'll use it first to unpack two very simple implementations that work great for beginning investors, or for an investor with modest funds. Then I'll provide some comments about using it for investors with substantial funds.

A $40,000 portfolio

When we get to $20,000, we have enough money to split off 30% of our stock allocation to meet the minimum requirement of an international stock fund. One good choice is the Vanguard Total International Stock Index Fund (VGTSX), which also has a $3,000 minimum. Ignore the International Bond box at this point.

A Full-chart portfolio

As our portfolio grows, we can work our way down through in the chart. At $110,000 we'll have enough money to make the minimum $3,000 for all of the boxes, except for the international emerging markets. At $200,000 you will have enough to cover the entire investment tree. You can find funds at Vanguard, Fidelity, T.D Ameritrade, or most any discount broker. Lean heavily toward index funds or at least the lowest fee managed funds you can find.

The long-term payoff for implementing the full chart is and the simplest portfolio is about 1-2%/year. If your portfolio is $100,000 then the $1,500 extra return may not justify the time to implement the full chart. But as your portfolio grows beyond $100,000 the payoff grows proportionally.

Rebalancing

Let's assume it's the January 1 of some year and we have just set up our portfolio so that each asset class is within 1% of the target.

We ignore our portfolio for the entire year, during which our fund share prices rise and fall, we've probably reinvested dividends, and maybe added or withdrawn some money from the accounts. So our mix of stocks and bonds has drifted away from the targets. If they've drifted more than 3%, it's time to rebalance back to within 1% the target.

It's important to check our portfolio in this way once, or at most twice, a year. In 2013, for instance, stock funds increased about 30% while bond funds fell about 1.5%. So in that one year, your investments drifted far out of balance!

Rebalancing sounds easy - but it's not. Here’s why: Over time let's assume our stocks increase by 8% and our bond values increase by 1%. To rebalance we need to sell stock funds and use the money to buy bond funds. Think about that for a minute: we are supposed to sell "winners" so we can buy "losers." This is psychologically hard to do. But that’s what rebalancing requires - always. You must trust the strategy AND have the discipline to carry it out. Rebalancing is at the core of the whole strategy.

It’s more logical than it sounds. Think about this way: Rebalancing is the only way to “buy low and sell high.” Sounds better, doesn't it?

Mechanics

If we only have 2-3 funds and they are all in one account, rebalancing is very easy. Even if our portfolio is in 2-3 different accounts at the same institution, such as an investment account, our retirement account, and our spouse's retirement account, we can still rebalance pretty easily using our financial institution’s website.

But many people have investments in more than one institution. For example, we might have a 401K through our employer at Fidelity, our spouse might have a 401k at T. Rowe Price, and we might have a taxable investment account at Vanguard. This makes rebalancing much more difficult! Our primary institution may allow us to import data from the other institutions in a way that allows us to manage our asset allocation all in one place. But there are a couple of other ways.

In my case, I use both - Quicken provides the overall asset allocation as well as the asset allocation for every account, regardless of what institution it's in. I use this data in the context of the spreadsheet to determine exactly what dollars to exchange from where to where.

Taxes and Asset Allocation

I am certainly not an authority on income taxes. Robin and I have long worked with an accounting firm to do our taxes and also to help us with occasional tax planning. But along the way I learned a few things that I will pass along:

Get a good tax professional to help you with your taxes at year end, one who is also able to help you with tax planning when you need it.

Do not let taxes drive your investment decisions. It makes no sense to carefully minimize management fees but ignore tax efficiency. So take the time to understand the implications of taxes so you can factor them in when it fits. I've prepared another page to help you with this:Mutual Fund Distributions & Taxation. Please be sure to check it out.

Every October/November analyze your expected tax liability for that year. It may be a good year to sell some long-term gains at zero or very low tax, so long as you keep your total income in a low enough bracket. Or if you've taken lots of gains in the year, it may be time to sell some losers for tax purposes. For more on this see Tax-Gain Harvesting.

Gold and real estate?

Over the very long term gold has produced no real return, meaning that it has just kept up with inflation. There are times of speculation when people make a lot of money in gold, and times when they lose a lot of money. My advice: stay away from trying to time the market, stay away from speculating in precious metals, stay away from speculating - period.

Real estate is a bit different. Leveraged real estate as an investment over the very long term has generated returns similar to the stock market. In the right locations, some people make good money on leveraged real estate. To do so takes a lot of time and a certain temperament. If you are “wired up” to enjoy real estate as a hobby, good luck. But... for me, a REIT (Real Estate Investment Trust) mutual fund is as close as I’m willing to get.

What's next?

This web page deals with the asset allocation of our "financial capital." Another interesting concept is our "human capital," which we can also factor into our asset allocation. For more on this, check out Human v Financial Capital.

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